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The raffish charm of fundamental indexing

A friend of mine used to torment himself with visions of a suave bogeyman named Dex. The imaginary Dex was better looking, richer, and more virile in every respect. And he prevented my friend from forming meaningful relationships. Every attempt was self-sabotaged by the fear that somewhere out there lurked Dex, ready to steal his beloved away.

Yes, my mixed-up friend had trust issues. And so do I when it comes to fundamental indexing.

Fundamental indexing is the debonair Dex to good old passive investing in market cap funds.

It’s newer, glossier, cooler (flying under the beguiling ‘smart beta’ banner) and it has a smooth line in proprietary patter that promises good times ahead.

Fundamental indexing is hot

Come hither, Dex

I’m attracted to fundamental indexing because it offers the chance to capitalise on the value premium. That premium has been worth around 3.5% per year to UK investors over the last 50 years.

There are a few fundamental indexing options available in the UK. First Trust Advisors AlphaDEX (note the Dex!) ETFs are the latest sophisticates, but the main players are the Invesco Powershares FTSE RAFI ETFs.

So how do these smart beta trackers work?

Inside the mind of the Dex

The first thing to note is that fundamental ETFs do not follow a traditional market cap index.

In other words, if company A is ten times the size of company B by market value then it does not automatically get ten times the presence in a fundamental index. That style is out like corduroy slacks.

Traditional market cap indices struggle to defend themselves against the accusation that they bloat up on overvalued equities, mechanically shoveling in more of the hot stuff like a compulsive eater – especially when the market is frothy.

In contrast, fundamental indices are meant to break this impulse by choosing equities according to a different menu.

In the case of the FTSE RAFI ETFs, their index encompasses a broad universe of equities, just like a vanilla index tracker.

However the FTSE RAFI indices rank their constituent companies not by market cap, but by four valuation metrics:

These company ‘fundamentals’ are well known health indicators that transmit information about the underlying state of the business.

They are also the source of the value premium, and fundamental indices are tilted in favour of equities that are cheap on those measures.

Also, because a RAFI index uses the average of the last five years’ worth of sales, cash flow and dividends for each company, its rankings are less influenced by short-term noise than a market cap index.

And that’s a good thing…

Who cares what the world thinks? As long as I have you, Dex

…but what if that noise turns out to be news? (Think what 3D printed guns might do to Smith & Wesson!)

Then the RAFI indices will be more slow to adapt to the new reality.

Every time a RAFI index rebalances (once a year) it’s mostly using historical data to determine its rankings – data that only partially reflects the troubles of a recently impaired firm. So whereas distressed firms automatically sink in a market cap index, they actually rebound back up a fundamental index.

Hence fundamental indices favour companies in trouble.

That’s absolutely fine if you believe the market generally over-reacts to bad news, and such companies are reputedly the source of some of the value premium. But we underestimate the wisdom of the market at our peril, and a strategy that doesn’t screen for distressed companies piles on the risk as well as the potential for greater returns.

Dex stripped

The risks of fundamental indexing are highlighted by a comparison of the Powershares FTSE RAFI 100 ETF (PSRU) against its market cap rival – the iShares FTSE 100 ETF (ISF).

The FTSE 100 suffers from diversification risk in the first place, but the fundamental version is even more concentrated:

  • 52% of PSRU is devoted to its top 10 holdings versus 48% of ISF and 37% of Vanguard’s All-Share tracker.
  • Over 10% of PSRU is in BP – its number one holding. Whereas ISF has just shy of 8% in its top-placed company, HSBC.
  • 47% of PSRU is concentrated in the financial and energy sectors versus 38% of ISF.

PSRU’s loadings are the natural outcome of its value tilt – the source of its potential to beat the pants off the market, but also the source of its volatility.

Fundamental products are also typically more expensive than market cap trackers and PSRU is no exception. The Ongoing Charge Figure (OCF) is 0.5% versus 0.4% for ISF and a tiddly 0.1% for VUKE – Vanguard’s FTSE 100 ETF. And that doesn’t take into account costs that show up in tracking error.

Dex’s midnight runner

Riskier, darker, more intense, more money… how can you resist the RAFIsh charms of fundamental indexing?

Well, in this follow-up post, I explain why I have my doubts.

Take it steady,

The Accumulator

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{ 8 comments… add one }
  • 1 Mark Carter May 8, 2013, 11:36 am

    Interesting.

    It’s probably not going to happen, but the irony is that if the whole world suddenly switched to fundamental indexing, then they would probably find that market-weighted indices would outperform. Growth shares would be systematically underweighted whilst declining companies would be systematically overweighted.

  • 2 Greg May 8, 2013, 1:16 pm

    @ Mark
    No they wouldn’t. Trackers are still a small minority of the money invested.

    If all active funds took up an an equal weight index, for example, as their benchmark then that might have a significant effect.

    Note that non-cap weighted doesn’t necessarily mean less growthy. (It does in the case of the RAFI funds though!) The mega-caps in the FTSE are hardly growth stocks.

  • 3 Phil May 8, 2013, 1:24 pm

    I like the idea of fundamental ETF’s but they look a bit expensive to me.

    According to key investor information document (KIIF), the Powershares RAFI 100 has a maximum entry charge of 3% and a maximum exit charge of 3% too.

    The ongoing charges fee of 0.5% is just about acceptable, but throw in a bid-offer spread of 0.39% (my broker’s website) and these other charges and I’ll put my money elsewhere.

    This is a shame because the idea is good.

  • 4 Phil May 8, 2013, 1:33 pm

    I’m talking nonsense.

    If you go through your broker there are no entry or exit fees.

    Apologies.

  • 5 PC May 8, 2013, 2:15 pm

    I’m a bit suspicious of the amount of attention fundamental indexing seems to be getting – it makes me feel like I’m being sold something

  • 6 Neverland May 8, 2013, 3:06 pm

    So…basically a way for a fund manager to quadruple the fees on an index tracker product?

    You bet you are being sold something

    Do you think that by changing the weighting of some stock in the FTSE-100 index by a paltry 5-10% you are going to make back an extra 0.3% a year in additional charges?

    Er, no thanks

  • 7 Greg May 8, 2013, 6:12 pm

    @Neverland

    Actually the behaviour can be significantly different (though not especially so in the case of the RAFI funds). I’m very keen on getting to know these strategies as I don’t like cap weighting, but am yet to dip my toe in.

    I’m mainly concerned that the stocks the minimum volatility funds are weighted towards are the ones that seem really overvalued right now, the exact opposite of what one would naively expect! (I would like to see a volatility optimising ETF that starts off with a high beta screen though! e.g. lumping together miners, tech & and retail in a way to maximise anti-correlation between them.)

    However, I’ll let TA express his reservations first!

  • 8 PC July 7, 2013, 3:45 pm

    smart beta sounds like the same idea – as described by the Economist http://www.economist.com/news/finance-and-economics/21580518-terrible-name-interesting-trend-rise-smart-beta.

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